Non-life insurers and reinsurers are exposed to physical risk through property and catastrophe losses, which are becoming more frequent and severe due to climate change
Life insurers are more exposed to the transition risk that affects the assets in their investment portfolios, due to their high investment leverage
London:
The UK’s latest supervisory climate stress test for banks and insurers is the world’s toughest yet, Fitch Ratings says, with some institutions’ capital ratios under the 30-year scenarios likely to fall close to, or even below, regulatory minimums.
However, the results, due to be published by the Bank of England (BoE) on 24 May, should not trigger undue investor concern because they will not be used to set capital requirements.
Instead, the BoE and the participants will use the results to assess vulnerabilities to climate risks, understand the challenges to their business models, and enhance their risk management of climate-related financial risks.
The BoE’s 2021 Climate Biennial Exploratory Scenario test explores the resilience of the UK financial system to the physical and transition risks under three climate pathways: ‘Early Action’ with transition to a net-zero emissions economy over 2021-2050, ‘Late Action’ with a delayed but then more intense transition over 2031-2050, and ‘No Additional Action’, with no new climate policies implemented.
‘Early Action’ is the least stressful scenario, as it assumes prompt action limits risk.
‘Late Action’ causes the highest transition risks, which we would expect to trigger significant credit losses in those corporate sectors that must adapt the most. ‘No Additional Action’ leads to the highest physical risks.
The BoE test is tougher than last year’s French climate test. It assumes higher peak carbon prices and greater global warming, and it limits credit for the management actions that firms could take to mitigate the effect of the scenarios on their business models.
“In practice, we would expect companies to adjust their asset and liability profiles significantly over time to reduce their exposure to transition and physical risks,” said Fitch.
Consequently, regulatory capital breaches under the BoE scenarios do not signal that breaches in reality are likely.
For banks, the test focuses on the credit risk in loan books. Banks with significant retail mortgage portfolios are likely to face steep increases in provisions given the need to adapt properties to meet net-zero targets, which could be costly for borrowers.
“The UK’s housing stock is among the oldest in Europe and we expect a sizeable proportion of homes to require expensive retrofits or to be uneconomical to upgrade under the scenarios, leading to market value reductions,” said Fitch.
Non-life insurers and reinsurers are exposed to physical risk through property and catastrophe losses, which are becoming more frequent and severe due to climate change.
Life insurers are more exposed to the transition risk that affects the assets in their investment portfolios, due to their high investment leverage.
The BoE test makes no allowance for how insurers could adjust premium rates, asset allocation or reinsurance programmes over the 30-year projection period.
The severe design of the BoE test brings forward the full climatic effects of each scenario as an instantaneous shock, which makes it likely that some insurers will breach their solvency ratios.
“In practice, we expect insurers to reprice their business and to steer their investment portfolios towards lower-risk sectors to reflect changing circumstances, and we believe they would be fairly resilient to the BoE scenarios if such management actions were taken into account,” said Fitch.
Climate stress tests are becoming more mainstream for banks and insurers around the world as supervisors become increasingly aware of the urgency in gauging the risks from climate change. Such tests could eventually feed into prudential capital requirements.
The Prudential Regulation Authority will report by end-2022 on whether changes to the UK’s regulatory capital regimes may be required to explicitly capture climate risks.